Saturday, 17 December 2016

ROE as a proxy for Competitive Advantage

The DuPont formula
ROE= (Net Profit/ Sales) X (Sales/ Assets) X (Assets/ Equity)
And we are left with:   
ROE = Net Profit/ Equity
The DuPont breakdown goes on to show why ROE is such a critical ratio for analysts and investors alike. 
It basically is combination of three ratios that reflect overall profitability and efficiency of a company. 
This breakdown also shows the bearing of six factors on ROE instead of the usual two that we assume are the beginning and end of it.

ROE as a proxy for Competitive Advantage:

Consistently High RoE figures do indicate that the company has a moat. 
As seen above in the Dupont breakdown of RoE, a company can have a high RoE 

  • either because it is able to sell its goods/services at a high margin 
  • or because  increase its returns by either selling its products at a high rate. 
Only the third option is undesirable i.e having a high leverage which would mean high indebtedness . 

Remember, we said a consistently high levels of RoE to be construed as an evidence of a moat. 
This is because the denominator of this ratio includes shareholders equity which in turn consists of   share capital plus retained earnings (also called reserves and surplus)
Share holder's equity= Share capital + Retained earnings
Now as the company generates higher returns on equity, the profits are added to the retained earnings. 
So the denominator of ROE keeps increasing and so either the company has to
  •  keep showing growth in its profits or 
  • find ways to reduce the denominator. 

The company can do that by 
  • either paying higher dividends 
  • or buying back shares
- both strategies lead to gains for shareholders. 

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